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Posted 2/17/2003
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3 investing myths you shouldn't buy into
There are no truths, only risks. Three down years don't guarantee an up year. Buy-and-hold forever is no guarantee of success. And interest-rate cuts guarantee nothing ... absolutely nothing.
By Bill Fleckenstein
If we could just bundle all those investing myths and send them packing, everybody would be better off. Good riddance to: buy and hold forever; past returns suggest future riches; interest rates down, stock prices up; the market can't be down x years in a row. And not to forget about the economic arena, Alan Greenspan's "productivity" -- his excuse for rationalizing the bubble -- would be first in line for a one-way ticket to oblivion. Sadly, myth has turned to devastating reality.
Last week, the wizard of the Fed appeared before the Senate Banking Committee. Apropos of the damage that he did not own up to, Bob Herbert of The New York Times recently ran a very disturbing op-ed piece "A Crush of Applicants." Had Greenspan been an eyewitness to the spectacle that Herbert described, this is what he would have seen:
"Huge, unexplained traffic jams began building up on the North Side of Chicago last Tuesday morning. Drivers struggled for half an hour or more to travel just four blocks. The police had to close entrance and exit ramps at a couple of spots along Lake Shore Drive. Baffled officers raised their arms in frustration as motorists demanded to know what was going on."
Herbert continued: "The traffic crush was caused by people desperate for jobs. Rumors that job applications for a Ford assembly plant would be accepted at a community college had swept through several of the city's neighborhoods. Chicagoans by the thousands responded, turning out in bitterly cold weather for a shot at gainful employment. The first arrivals showed up well before dawn. By 7 a.m. more than 2,000 people had lined up outside Truman College, and the hopefuls kept coming throughout the morning. They shivered, and tears from the cold ran down some of their faces. It was like a scene out of the Depression. The rumors were false."
Lexicon artist
This is a sad example of the wreckage that has ensued since the mania was fomented by Federal Reserve Chairman Alan Greenspan. So far, he has received a pass for the consequences of his reckless behavior. He does not deserve the pass. He and the other clowns at the Fed ran monetary experiments in the late 1990s while they rationalized all their errors away with productivity and hedonic adjustments. Now we are beginning to see some of the fallout, with the predawn crush of unemployed Chicagoans just one stark, poignant example of how bad things are. Recently, the Fed described our problems as a mere soft spot. To repeat my initial reaction to this phrase, if what we're going through is a "soft spot," I'd hate to see what a hard spot looks like, though I'm afraid we're liable to find out.
This is not to imply that if someone else were running the Fed now, there would be much that they could do. As I said frequently during the mania and since then, bubbles can only be prevented, not cured. Once we've had one, we mostly have to just let time and the markets work off the excesses caused by the misallocation of capital. Attempts by the government and the Fed to fight off this destruction will only make things worse in the end.
The long run is a long shot
Meantime, the mania's aftermath has seen no shortage of investing myths masquerading as truths. But a study by three academics from the London Business School, which was recently reported in a great Wall Street Journal article titled "Long-Term Risk Is Underestimated," goes a long way toward debunking these myths. To begin with, professors Elroy Dimson, Paul Marsh and Mike Staunton dispelled the buy-and-hold notion by observing that "not only can markets take a long time to recover, but also investors generally underestimate what the safe long-run period is to hold stocks."
Many times, I have made the point that for me, a rational long-term horizon is say, three to five years. Often, you can feel like you have some sense of how things might play out over that time frame. But, in my opinion, to think you could have a reasonable basis for a 10- or 20-year investment is kind of crazy. Nevertheless, people sometimes fall back on that to justify holding on to prior losers. Just how dangerous this is can be seen in another finding of the study, which is that "out of 16 major national stock markets, investors from only five would have been guaranteed positive annual returns over every 20-year period during the past century."
That's pretty staggering. Most people feel it's a slam-dunk that they're going to win over 20 years. Of course, that presupposes they won't fall prey to another problem, which is survivor bias. It's quite possible that even if the market worked out over 20 years, the handful of stocks they picked might not, as most people who bought Internet stocks can now see clearly.
Chiseled-in-stone-cold comfort
The professors then highlighted the myth and risk of "basing expectations on past returns." They pointed out that "historical analysis can never reveal the full range of century-long returns that might have been experienced by investors (the emphasis is mine). An individual country confronts many possible futures, but can report only one past." So, this should be food for thought for most people, who automatically assume that things will work out over time. Further, it should alter the fundamental notion of risk -- from the "risk" that the market will take off without you, to the risk that you will make an investment and then be forced to sell at a price considerably less than what you paid for it.
The article also exploded one of the present-day myths that I refer to as arm-waving. You know, the market's been down three years in a row, and therefore it can't decline for a fourth, as posited by so many pundits. The professors' response to that is: "The history of stock market performance shows that across 16 markets, the probability of a fourth down year is 40%. That also happens to be the probability of any other year being a down year."
No Dr. Spock for stocks
Along those lines, I'd like to make the point that there are no ironclad rules of investing. If I had told you three years ago that we would have 12 rate cuts and that they would not inspire the stock market, people would have said I was crazy. Similarly, one of the other big bull arguments is that rates are so low, stocks have to go up. That doesn't happen to be true, either. Obviously, if all things are equal (which they rarely are), and you're buying a stock at 10 times earnings, and interest rates were to be cut in half, there is some chance that you might be willing to pay as much as twice as much for that same stream of earnings. However, there is no law that says this will always be the case. If rates collapsed because the economy was doing poorly, there's some chance those earnings could fall away. This is the situation that exists in Japan, and now here in the United States.
So, falling rates don't guarantee higher prices. Three down years don't guarantee an up year this year. The Fed cutting rates doesn't guarantee that things will get better. There are no absolutes in investing. All one can do is to try to assess the probabilities of what the potential outcomes might be and to incorporate those probabilities, as best the circumstances permit, into managing risk (defined as the chance that you will lose meaningful amounts of money) and reward. We're all going to be wrong in our investments from time to time. The trick is to not get carried out when you make your mistakes.
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